Exxon's desire to quit, which the sources said was due to prospects of slim profits from the estimated $50 billion West Qurna-1 project, contrasts with a deal it signed a year ago to explore in Iraq's autonomous northern Kurdish region, where incentives are better.

Baghdad deemed the Kurdish deal illegal and promised to punish Exxon by ripping up its contract for West Qurna-1, which has reserves of 8.7 billion barrels.

Exxon executives this week told U.S. State Department officials it was looking to sell its 60 percent stake in the project, diplomats from two Western countries said.

"Exxon is telling Baghdad: 'We are letting you know we're looking to leave,'" one of the diplomats said. "They are shopping around and looking at all the options."

Exxon declined to comment, as did the U.S. State Department.

Exxon's departure from southern Iraq now hinges on its ability to find a company willing to buy out its stake in West Qurna-1, industry sources say.

"If they can find the right buyer, they will pull out," said an industry executive. "It's an unusual move for Exxon. They usually don't give up."

Industry sources said Baghdad is keen to replace Exxon with companies from Russia, or even China, to teach Western oil majors a lesson. This could alter the diplomatic and political influences in Iraq but, technologically, Chinese and Russian companies may have less to offer the oil sector.

The U.S. major was the first to flex its muscles and challenge Baghdad's authority by signing up for exploration deals with the Kurdistan Regional Government (KRG). Others, such as Chevron, Total and Russia's Gazprom Neft followed just months ago.

Exxon stock barely budged on the news, indicating there may be more at stake for Iraq, Kurdistan and regional politics than for Exxon shareholders.

The dispute over oil contracts is part of a broader battle between Baghdad and Kurdistan over oil rights, territory and regional autonomy that is straining Iraq's uneasy federal union.

Iraq's Shi'ite Prime Minister Nuri al-Maliki has gone so far as to ask U.S. President Barack Obama to force Exxon to pull out of West Qurna, saying its actions are a threat to peace.

While Iraqi Deputy Prime Minister Hussain al-Shahristani met Exxon executives in Baghdad this summer and threatened to kick the company out, practical and legal constraints limit Baghdad's scope for action..

West Qurna-1 now pumps about 400,000 barrels per day of Iraq's overall production of just over 3 million bpd.

Shahristani declined to say on Thursday whether Exxon was pulling out but told Reuters in an email that Baghdad was sticking to its line that all contracts signed with the KRG without the approval of the central government were illegal.

"All companies that entered in such contracts were asked to cancel them or pull out," he said. "Exxon Mobil can be contacted about their decision."

Despite Baghdad's tough talk, Exxon Chief Executive Officer Rex Tillerson said in March the company was committed to expanding output at West Qurna, where it is in charge, as well as exploring in Kurdistan.

And it has been business-as-usual for Exxon at West Qurna-1, which generates a hefty chunk of Iraq's central government revenue.

Exxon, with minority partner Royal Dutch Shell, signed up in early 2010 for the project, which targets output of 2.825 million barrels per day by 2017. By the end of last year, the pair had spent just under $1 billion.

West Qurna-1 is central to Baghdad's plan to more than triple output in the next decade and to rival Saudi Arabia, the world's top oil producer. Iraq now ranks second behind Riyadh in the Organization of the Petroleum Exporting Countries.

But the pace of expansion has been slow. Exxon, like other foreign operators, has complained that infrastructure bottlenecks, payment delays and red tape are hampering progress. Tough terms and slim margins on Iraq's service fee contracts are also drawbacks.

It was that frustration, say oil executives, that led Exxon to move into Kurdistan, which offers more lucrative production sharing contracts and a safer operating environment.

Exxon is now raising its profile in Kurdistan, with drilling set to begin in a few months. A senior Exxon delegation was last week in the region's capital Arbil, where the company is setting up an office, they said.

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